With the budget 2013-14 a new investment option has been introduced i.e. Inflation Indexed Bond which claims to save your money as the returns are expected to match the returns with inflation.
India’s first inflation indexed bonds to be launched on June 4, 2013. These 10-year bonds will have a fixed coupon rate and their principal value will be linked to the Wholesale Price Index (WPI). In order to maintain liquidity, the same bonds will be reissued every month after deciding their principal based on the inflation numbers.
Let us understand the complexity of this option of investment
What is an inflation-indexed bond?
Inflation-indexed bonds (also known as inflation-linked bonds) are bonds where the principal is indexed to inflation. Inflation-linked bonds aim to provide security of capital and protection against inflation. Inflation-Indexed Bond guarantees a real return.
A theoretical definition says “A bond that guarantees a return higher than the rate of inflation if it is held to maturity. Inflation-indexed bonds link their capital appreciation, or coupon payments, to inflation rates. Investors seeking safe returns with little to no risk will often hold inflation-indexed bond.”
These bonds were being issued with an aim to protect savings of poor and middle classes from inflation and incentivize household sector to save in financial instruments rather than buy gold.
Till recently, interest earned on bank deposits were negative keeping in the mind the high inflation rate, but it claims the returns on these bonds linked to the wholesale price index, investors can be assured that the returns will beat inflation.
How does such bond operate & How does the interest is calculated?
The principal amount is linked to the inflation rate so that any increase or decrease in the inflation rate automatically results in an adjustment in the principal. Most debt products such as fixed deposits (FDs) or regular bonds provide returns that are not protected against inflation. If a bank FD pays an interest rate of 9% per annum and inflation averages 9.5% that year, the investor loses money in real terms. This is because the real rate of return of the FD in this case would be -0.46%.
Example: For example, if a 10-year bond has a face value of Rs 1,000 and the annual coupon rate is 10%, the investor will get Rs 100. Now, if the inflation index in the next year rises by 12%, the principal will be adjusted to the inflation rate and get raised to Rs 1,120 [1,000×(1+12%)]. So, the next year the investor will earn Rs 112 as interest, which is 12% higher than the original amount. This way the returns from the investment will be safe from the incessant march of rising prices.
And the adjusted interest payment will be calculated as;
On maturity, the investor gets back the higher of the adjusted principal or the face value.
What is the tenure of the Bond?
Theses bonds come with a 10-year tenure and fixed coupon or interest rate.
What is the mode of payment of interest?
Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and the nominal coupon rate. Periodic coupon payments are paid on the adjusted principal.
What are the tax benefits?
Sorry 🙁 theses bonds will not receive any special tax benefits and existing income tax rates will be applicable beyond the prescribed limit.
Is there an option to exit before the term ends?
The instrument will be traded like any other government security, thus giving investors a chance to exit their investments.
Will it be really beneficial investment?
Since the rate of return is based on wholesale inflation and not as per the higher consumer price inflation, investors will receive negative returns on their investment. Although inflation-indexed bonds prove beneficial during times of high inflation, they underperform when the economy goes through a deflationary phase and prices actually come down. In such a situation, the Inflation Index Bond will give lower than the coupon rate because the principal would get adjusted below Rs 1,000 (as per the stated example above). However, this is only a theoretical risk. A decline in wholesale prices is not even a remote possibility in India.
Another drawback of these bonds is that they have been indexed to the WPI and not the Consumer Price Index (CPI). For most investors in bonds, the CPI is the more relevant index. Consumer prices matter to them in day-today life than wholesale prices.
What you need to check before investing?
Before investing, see the initial coupon rate on the bond. A coupon close to the prevalent bank fixed deposit rate would be the best bet.